Legal Restrictions on Raising Private Capital

Securities offerings are governed by the Securities Act of 1933 and rules thereunder. The relevant rules, with respect to a private offering of a startup, are those related to exemption from registration.

Legal Restrictions According to U.S. Law

According to Section 4(2) of the Securities Act of 1933, there is no need to register shares (or deliver a prospectus) in a private sale of securities. U.S. courts have laid down certain conditions for exempting private sales from registration. Generally, the following requirements have to be met for the exemption to be available: (1) the offeree receives or is given access to material information about the company; (2) the issuance of the securities is performed directly and not via means of mass distribution; (3) the number of offerees and buyers is limited; (4) the buyers will not act in practice as distributors of the shares (in other words, they will not purchase them with the aim of reselling them in the short-term).

Most investments of private capital in startups qualify for the exemption. However, it is still best to rely on clear rules such as those contained in Regulation D. Regulation D was promulgated by the Securities and Exchange Commission (SEC) in order to provide definite (although not exclusive) rules for exemption from registration. The rules in Regulation D exempt the sale of securities by companies from registration in one of three ways:

• An issuance in accordance with Rule 504— The sale of securities for a total amount of up to $1 million in a period of 12 months is exempt from registration with no other conditions.

• An issuance in accordance with Rule 505— The sale of securities for a total amount of up to $5 million in a period of 12 months is exempt from registration provided that all of the investors save 35 are "accredited investors" (i.e., 35 investors may be investors that are not accredited investors). This term generally refers to the following investors: banks, brokers, institutional investors, managers and directors of the company, or individuals with net assets exceeding $1 million or an income exceeding $200,000 per year ($300,000 per household/couple).

• An issuance in accordance with Rule 506— This refers to the sale of securities for an unlimited amount to "accredited investors" and to another 35 investors who are not "accredited investors." However, under this regulation, which does not limit the amount of the offering, the "non-accredited" investors are required to represent that they are able, either alone or together with their representatives, to assess the benefits and risks involved in the investment.

In order to meet the Regulation D rules, investors are customarily required to represent in the investment agreement that they are indeed "accredited investors."

How to Meet the Legal Requirements

As mentioned above, a private placement is subject to domestic and occasionally also foreign securities laws, as well as rules deriving from the law of contracts. The following discussion addresses both these sets of laws.

• The number and identity of the offerees and buyers— As a rule, securities should not be offered to a large number of offerees, who are not "accredited investors" under U.S. law. In any case, shares should be offered strictly to investors who are able, either alone or with the assistance of consultants, to understand the meaning of the investment and to bear the risk involved in such investment. This would also prevent claims by customers with respect to fraud or exploitation under contract law.

• The offering document— The document pursuant to which the securities are offered (usually the business plan or a PPM—Private Placement Memorandum) should include all the material information about the company. In addition, each document should be numbered and a record should be kept of the person to whom it was given, thus proving the number of offerees and that all material issues were duly disclosed.

• Personal negotiations— Negotiations should be conducted in person with each investor in order to eliminate the fear that the sale of the shares will be classified as a public offering requiring the filing of a registration statement. In addition, each investor should be given the opportunity to perform a due diligence process which would prevent claims of misrepresentations and claims under the law of contracts.

• The investment contract— Representations should be obtained with respect to (1) the investor's experience in investments of the type in question and his or her being an "accredited investor" for purposes of U.S. law; (2) the investor's ability to bear the risk and his or her understanding of the subject matter of the investment; (3) the fact that he or she had conducted a due diligence process to his or her satisfaction; (4) his or her understanding of the restrictions imposed on the sale of shares which are not listed for trade and his or her readiness to adhere to them.